CHOICE OF ENTITY CONSIDERATIONS

IN FORMING A NEW BUSINESS AND

AVOIDING PERSONAL LIABILITY IN

BUSINESS ENTITIES

Prepared for Dallas Bar Association

Solo and Small Firm Section

April 6, 2011

Steven E. Clark

Kennedy Clark & Williams PC

1700 Pacific Avenue, Suite 1280

Dallas, Texas 75201

Tel.:214-979-1122

Fax:214-979-1123

Email: sclark@kcwfirm.com

Website: www.kcwfirm.com

ii

TABLE OF CONTENTS

Page

I. Choice of Business Entities in Texas 1

A. Types of Business to Choose in Texas 1

B. Overview and Comparison of Entities 2

II. Avoiding Personal Liability in Business Entities 9

A. Comparison of Entities 9

B. Indemnity Provisions 20

C. Impact of Management on Liability 21

D. Other Sources of Liability 21

III. Final Advice 27

1

CHOICE OF ENTITY CONSIDERATIONS IN FORMING A

BUSINESS AND AVOIDING PERSONAL LIABILITY IN

BUSINESS ENTITIES

I.

Choice of Business Entities in Texas

A. What types of business entities are available in Texas?

Generally, businesses are created and operated in one of the following forms:

· Sole proprietorship

· General partnership

· Limited Partnership

· Registered Limited Liability Partnership

· Limited Liability Company, and

· Corporation.

The most advantageous business entity in a particular situation depends on the

objectives of the business for which the entity is being organized. In most situations, the

focus will be on how the entity and its owners will be taxed and the extent to which the

entity will shield the owners of the business from liabilities arising out of its activities.

The focus of this paper will be on Texas law. Today, all business entities formed

after January 1, 2006 are governed by the TBOC, which was enacted by the Texas

legislature in 2003. Entities in existence prior to this date may continue to be governed

by prior Texas law, which was otherwise repealed on January 1, 2010. Prior applicable

Texas law includes the following statutes:

1. Texas Revised Partnership Act (―TRPA‖)1;

2. Texas Revised Limited Partnership Act (―TRLPA‖)2;

3. Texas Limited Liability Company Act (―TLLA‖)3; and

1 Article 6132b, § 1.01 et seq., V.A.C.S.

2 Article 6132a, § 1.01 et seq., V.A.C.S.

2

4. Texas Registered Limited Liability Partnership Act (―TLLP)4.

5. Texas Business Corporation Act (―TBCA‖)5,

The TBOC states that its provisions applicable to corporations may be officially

and collectively known as ―Texas Corporation Law.6

B. Overview and Comparison of Entities

1. Sole Proprietorship

In a sole proprietorship, a single individual engages in a business activity without

formal organization. One can create a sole proprietorship just by going into business

unless the business is incorporated or organized as another business entity recognized in

Texas.

If a sole proprietorship is conducted under an assumed name (a name other than

the surname of the individual), an assumed name certificate (commonly referred to as a

―d/b/a‖) should be filed with the office of the county clerk in the county where a

―business premise‖ is maintained. If no business premise is maintained, then an assumed

name certificate should be filed in all counties where business is conducted under the

assumed name.

It is difficult to maintain a sole proprietorship that is growing with need for

capital, since investors coming into the business typically require an equity participation

in the business. However, the individual is generally entitled to use business losses

against other types of income.

3 Article 1528n, § 1.01 et seq., V.A.C.S.

4 Tex.Rev.Civ.Stat.Ann., art. 6132b, § 1.01, et seq. (Vernon Supp. 1999)

5 Tex.Bus.Corp.Act arts. 1.01 et seq., V.A.C.S.

6 TBOC § 1.008(b).

3

2. General Partnership

A Texas general partnership is an oral or written association among two or more

principals with a community of interest in a venture, with an agreement to share profits

and losses, and a mutual right of control or management of the enterprise.7 A partnership

may merge with a corporation, LLC or another partnership and convert from one form of

entity to another without going through a merger or transfer of assets.

3. Limited Partnerships

A limited partnership is a partnership formed by two or more persons, having one

or more general partners, and one or more limited partners.8 A limited partnership is not

currently subject to franchise tax, and a limited partner‘s share of income (other than a

guaranteed payment for services) is generally not subject to self-employment tax.9 One

downside to a limited partnership is the additional record keeping and tax returns

required when another entity is created to be the general partner.

Unless otherwise provided, a partnership interest is assignable in whole or in part,

and the assignment will not dissolve the limited partnership.10

If a general partner

assigns all or part of its rights as a general partner, a majority in interest of the limited

partners may terminate the general partner‘s status as a general partner.11

Texas law permits a limited partnership to merge with a corporation, LLC or

another partnership, and to convert from one form of entity to another without going

through a merger or transfer of assets.12

7 See Schlumberger Technology Corp. v. Swanson, 959 S.W.2d 171 (Tex. 1997).

8 TRPA § 1.02(6) TBOC § 1.002(50).

9 IRC § 1402(a)(13).

10 TRLPA § 7.02; TBOC § 153.251.

11 TRLPA § 7.02(a)(4); TBOC § 153.252(b).

12 TRLPA § 2.11; TBOC § 10.009. TRLPA § 2.15; TBOC §§ 10.106, 10.101.

4

A certificate of formation must be filed containing the name of the entity, stating

it is a limited partnership, with the name and address of the general partner, the address of

the registered office and the name and address of the registered agent, and the address of

the principal office where books and records are kept.13

A filing fee of $750.00 must be

paid with the filing of the certificate of formation.14

4. Limited Liability Partnership

A Limited Liability Partnership (LLP) is a general partnership in which the

individual liability of partners for partnership obligations is limited. LLPs were initially

available only to certain professionals pursuant to the provisions of the Texas

Professional Corporation Act.15

Criticisms of this limitation lead to the enlargement of

LLP provisions to apply to all partnerships, and to the addition of the requirements of

LLP registration, use of LLP status or initials in the partnership name, and maintenance

by LLPs of liability insurance.

To attain LLP status, 3 requirements must be met: 1) the LLP must include in its

name the words ―registered limited liability partnership‖ or the abbreviation ―L.L.P.‖ as

the last words or letters of the name;16

2) a partnership must file with the Secretary of

State an application plus a fee of $200.00 per partner17

; and 3) the partnership must carry

insurance, or provide funds of $100,000.00 to cover errors, omissions, negligence,

incompetence, or malfeasance.18

13

TBOC §§ 3.001, 3.005, 3.011. See also, TRLPA § 2.01. 14

TBOC § 4.155(1). 15

Tex.Rev.Civ.Stat.Ann., art.1528e. 16

TRPA § 3.08(c); TBOC § 5.063. Neither ―R.L.L.P.‖ nor ―L.P.‖ is acceptable. 17

TRPA § 3.08(b)(3); TBOC § 4.158. For a foreign LLP, the fee is $200.00 per Texas partner, not to

exceed $750.00. TRPA § 10.02(c). Registration is effective for a period of one year. TRPA § 3.08(b)(5). 18

TRPA § 3.08(d)(1); TRPA § 3.08(d)(1).

5

5. Limited Liability Companies (“LLCs”)

An LLC is created when one or more persons file a Certificate of Formation,

similar to a certificate of limited partnership and articles of incorporation, with the Texas

Secretary of State with a $300.00 filing fee.19

The existence of the LLC begins when its

certificate of organization is issued by the Secretary of State.20

The name of an LLC

must contain words or an abbreviation to designate the nature of the entity, whether the

words ―Limited Liability Company,‖ or ―Limited Company,‖ or the acronyms LLC or

LC.21

The LLC may be structured to be governed by Managers, who are generally

equivalent to directors of a corporation, and are elected by the Members in the same

manner as directors are elected by shareholders.22

However, the LLC may also be

structured so that management is performed by the Members, analogous to a close

corporation or a general partnership.23

Any ―person‖ may be a Member or a Manager of

an LLC.24

Because of the broad definition of a ―person‖ under the Act25

, any individual,

corporation, partnership, LLC or other person may become a Member or Manager.

Managers may designate officers and other agents to act on behalf of the LLC.26

The

management and operation of the LLC are usually specified in a written agreement

referred to as the Regulations of the LLC, which are similar to the bylaws of a

19

TBOC § 3.001, 4.152(1), 4.154. 20

Id., § 3.04. 21

Id., § 2.03A(1). Limited may be abbreviated as ―Ltd.,‖ and Company can be shortened to ―Co.‖ 22

TLLCA § 2.13; TBOC §§ 101.302 – 101.304, and 101.306. 23

Id., § 2.12; TBOC §§ 1.002(51), 3.101, 101.251, 101.253, 101.302. 24

Id., §§ 2.13; TBOC §§ 101.302 - 101.304. TLLCA 4.01C; TBOC § 101.102. 25

Id., § 1.02(4). See TBOC §§ 1.001(51, 53). 26

Id., §§ 2.12; TBOC §§ 1.002(51), 3.101, 101.251, 101.253, 101.302. TLLCA § 2.21; TBOC §§ 3.103

and 101.254.

6

corporation or a limited partnership agreement.27

The regulations may expand or restrict

the duties (including fiduciary duties) and liabilities of Members, Managers, officers, and

agents of an LLC, and provide for their indemnification.28

If an LLC has members, managers, and officers, it may function similar to a

corporation. However, one advantage of an LLC is the ability to dispense with some of

the formalities required for operating a corporation, such as formal documentation of

meetings, or having annual meetings.

Limited liability companies are available by statute in all 50 states, with some

significant variances among state laws. An LLC must be created and filed with a state to

have effect. The owner of an LLC is called a member. LLCs can either be managed by

members, or by managers, who operate similarly to a board of directors. Texas allows

one member LLCs, though other states do not. In Texas, it is optional whether a

member‘s interest in an LLC is reflected by a membership certificate.

By default, an LLC with two or more members is taxed as a partnership, while a

single member LLC is disregarded for tax purposes, unless an election is made to be

taxed as a corporation. For an LLC selected to have corporate status, a subchapter S

election may be filed for members who qualify. LLCs may be treated as a corporation

for corporate income tax purposes, or be subject to a franchise tax like a corporation29

,

unlike a limited partnership.

The advantage of an LLC is that it brings together in a single business the best

features of all other business forms—a corporate-styled liability shield, and the pass-

27

Id., § 2.09A; TBOC §§ 101.051 - 101.053. 28

Id., § 2.20; TBOC §§ 8.002, 101.402, 101.401. 29

In Texas, an LLC is subject to the corporate franchise tax. Tex. Tax Code Ann. § 171.001.

7

through benefits of a partnership, in which all members can participate in the

management of the company without loss of protected liability status.

A member‘s interest in an LLC is personal property,30

but does not confer any

interest in specific LLC property.31

Membership interest may be evidenced by a

certificate if the Regulations of the LLC so provide.32

The Act generally allows even

more flexibility in structuring classes of members than is available in structuring classes

of corporate stock or classes of limited partnership interests.

An LLC membership interest is ordinarily considered to be a ―security‖ for

purposes of the Securities Act of 1933, and state blue sky securities laws. Thus, a sale of

an interest may be required to be registered under applicable securities laws, or through a

private offering, or other transaction structured to be exempt from registration

requirements. LLC interests are not ―securities‖ governed by Chapter 8, Texas Business

& Commerce Code, unless the interests are dealt in or traded on securities exchanges or

markets, or the parties expressly agree to treat them that way.33

Instead, such interests

should be classified as ―intangibles,‖ and a security interest would be perfected by a

financing statement filing.34

Generally, assignment of an LLC interest is similar to that

for assignment of a limited partnership interest, and does operate to terminate or dissolve

the LLC.

6. Corporations

A corporation is an independent legal entity, separate from the people who own,

control and manage it. The owners of a corporation are called shareholders. A

30

Id., § 4.04; TBOC §§ 1.002(54), 101.106. 31

Id. 32

Id., 4.05B; TBOC § 3.201. 33

B&CC §§ 8.102, 8.103(c). 34

B&CC §§ 9.106, 9.302(a).

8

corporation is managed by a board of directors (only one required, and a director must be

a natural person). The daily affairs are administered by officers (two officers are

required, president and secretary – one person may serve as both officers and be the sole

director). Generally, only shareholders who are also officers or directors have any role in

management of the corporation.

Corporations are formed to shield the shareholders, officers, and directors from

personal liability for the debts and obligations of the entity. Generally, shareholders have

limited personal liability for the business debts of the corporation.

The primary advantages of operating a business as a corporation include: i)

limited liability to shareholders; ii) centralization of management; iii) flexibility in capital

structure; and iv) status as a separate legal entity. Primary disadvantages are: i) expense

and formation; ii) statutorily required formalities; iii) tax treatment-double taxation for C-

corporations and restriction on the S-corporation; and iv) franchise taxes.

The Texas Secretary of State does not distinguish between corporations using

these designations. When a certificate of formation is filed with the state of Texas, either

a business corporation or a non-profit is created. Designations such as C, S, or 501(c)(3)

relate only to federal tax provisions. The taxable treatment of corporations is beyond the

scope of this paper.

A corporation, however, must comply with certain formalities to maintain this

limited liability protection. First, a business corporation is created by filing a certificate of

formation with the Texas Secretary of State. A Texas corporation is also required to

continuously maintain a registered agent and a registered office for the purpose of service of

process. Other corporate formalities, such as the creation of bylaws (sets forth rules

9

governing the operation of the corporation), issuance of stock (ownership in the

corporation), annual shareholder and director meetings, documentation of these meetings

and important directors' decisions, filing of separate corporate tax returns, must be

observed.

The only restriction the Texas Business Corporation Act and the Texas Nonprofit

Corporation Act place on who can incorporate or own shares in a corporation is that the

incorporator must be at least 18 years old.

II. Avoiding Personal Liability in Business Entities

A. Comparison of Entities

1. Sole proprietorship

Because there is no formal structure, the owner of a sole proprietorship is

personally liable to creditors for all business debts and any judgments, subject to

available exemptions under Texas law

This is not the entity of choice to avoid personal liability for business transactions.

A single member LLC would be a better choice, even if taxed as a sole proprietorship.

2. General Partnership

Like a sole proprietorship, general partners are personally liable for the debts of

the business, and for wrongful acts or omissions while acting in the ordinary course of

business or with authority for the partnership.35

Generally, all partners of a general partnership are jointly and severally liable for

all debts and obligations of the partnership.36

However, a partner who pays more than his

35

TRPA § 3.03; TBOC § 152.303. 36

TBOC § 152.304.

10

pro rata share has a right of contribution from the partnership or the other partners who

did not pay their allocable share.37

Prior to the enactment of the TRPA38

, Texas common law provided that the

relationship between partners was ―fiduciary‖ in nature, and that each partner owed the

other the fiduciary duties of ―complete loyalty,‖ ―due care,‖ and ―absolute disclosure.‖39

The courts also treated a joint venture40

as a general partnership, with each joint venturer

owing the same fiduciary duties to the other joint venturers.41

One of the stated goals of the 1994 Texas Revised Partnership Act was to reject

the strict fiduciary standards and duties imposed on general partners and joint venturers

under the common law, and to bring Texas law in line with modern business practices.

An agreement to share losses is no longer a necessary element of a partnership under the

TRPA.42

The Bar Committee comment to Section 4.04 of the TRPA specifically states

that the term ―fiduciary‖ is inappropriate to describe the duties of a partner, who, unlike a

trustee, can pursue that partner‘s own self-interest, and not solely the interest of fellow

partners or the partnership itself. However, the courts have not completely abandoned

the concept of fiduciary duty since the enactment of the TRPA.43

A common theme to

these cases is the lack of a written partnership agreement which addresses the ―conduct‖

37

TRPA § 4.01(c); 8.06(c); TBOC § 152.203(d); § 152.708. 38

The TRPA governs all partnerships after 1999. 39

Johnson v. Peckham, 120 S.W.2d 786 (Tex. 1938). 40

A partnership formed for a specific purpose, such as developing land, rather than a general partnership. 41

Rankin v. Naftalis, 557 S.W.2d 940 (Tex. 1977). 42

TRPA § 2.03(c); TBOC § 152.053. 43

See, e.g., Bohatch v. Butler & Binion, 977 S.W.2d 543 (Tex. 1998) (―We have long recognized as a

matter of common law that ‗[t]he relationship between …partners…is fiduciary in character…‖).

11

in issue. Past attempts to lower the ―fiduciary‖ standard in a written agreement have met

with resistance from some courts.44

The new standards of partnership conduct are set forth in TRPA §§ 4.03 and 4.04.

Under these provisions, each partner owes the other: 1) a duty of care; 2) loyalty; 3) an

obligation of good faith; and 4) duty of disclosure, i.e., the right of each party to obtain

access to the books and records of the partnership, and the duty of each party, upon

request, to provide complete and accurate information regarding the partnership. These

standards are considered to be ―minimum‖ standards which cannot be completely

eliminated by agreement of the partners, but can be specifically altered and defined by

the parties if not ―manifestly unreasonable.‖45

Any general partner has the power to bind the partnership for acts in the ordinary

course of the partnership‘s business, if the party with whom the partner is dealing is not

aware that such partner lacks authority to do so.46

The TBOC prohibits any restriction on

the rights of third parties dealing with the partnership.47

However, the partnership

agreement can include specific provisions for dealing with a partner who exceeds its

authority, including expulsion.48

44

See, e.g., Spiritas v. Robinowitz, 544 S.W.2d 710 (Tex.Civ.App.-Dallas 1976, writ ref‘d n.r.e.)

(managing partner not protected by exculpatory clause in agreement for unilateral actions taken in ―good

faith‖ that required unanimous consent of all partners). 45

TBOC § 152.002; TRPA § 1.03. This section provides the general rule that the terms of the partnership

agreement will govern the relationship of the partners and partnership, and that the TRPA will apply only

to the extent that it is not covered by the agreement or is in conflict with the agreement‘s express terms.

What is ―manifestly unreasonable‖ is to be determined by the courts. See Bar Committee Comment to §

1.03(b). 46

TBOC §§ 152.301, 152.302; TRPA § 3.02; 47

TBOC § 152.002(b)(7). 48

TRPA, § 6.01; TBOC § 152.501.

12

Unless the partnership agreement provides otherwise, each partner has the equal

right to participate in the management of the business.49

A managing partner stands in a

higher fiduciary relationship to other partners.50

Unless otherwise provided, a partnership interest is freely transferable.51

However, mere ownership of a partnership interest does not necessarily make the owner a

partner.52

A general partner always has the power to withdraw from the partnership, even

if the partnership agreement denies the partner the right to do so.53

Upon withdrawal,

unless the partnership agreement provides otherwise, the partnership interest of the

withdrawing partner is required to be redeemed.54

Dissolution is referred to as ―winding

up‖ in the TRPA.55

Withdrawal, bankruptcy, death of a partner, or transfer of a

partnership interest do not require a winding up of the partnership unless the agreement

provides otherwise.56

Winding up and termination are not synonymous.57

Under § 3.03 of the TRPA (TBOC § 152.303) a partnership is liable for loss or

injury to a person, or a penalty caused by or incurred from a wrongful act or omission of

any partner: 1) acting in the ordinary course of business of the partnership or 2) with

authority of the partnership. Except as to a registered limited liability partnership, all

partners are jointly and severally liable for all debts and obligations of the partnership

49

TRPA § 4.01(d); TBOC §§ 3.101, 152.203. 50

See, Hughes v. St. David’s Support Corp., 944 S.W.2d 423 (Tex.App.-Austin 1997, writ denied). 51

TRPA § 5.03(a)(1); TBOC § 152.401. 52

See TRPA §§ 5.03(a)(4), (b); TBOC § 152.402(3). 53

See TRPA §§ 1.03(b)(5); TBOC § 152.002(b)(5), TRPA 6.02; TBOC §152.503. 54

See TRPA §7.01; TBOC §§ 152.601 - 152.612. 55

TRPA § 8.01; TBOC §§ 11.051, 11.054, 11.057, 11.151, 11.314, 152.709. 56

Id. 57

See TRPA § 2.06; TBOC § 152.503. TRPA § 8.02; TBOC §§ 11.103, 152.701. A partnership continues

after an event requiring winding up, until the winding up of the business is completed, at which time the

partnership is terminated.

13

unless otherwise agreed by the claimant or as otherwise provided by law.58

Attempts to

allocate liability among the partners are generally ineffective against third party creditors.

A new partner admitted into an existing partnership does not have personal liability for

obligations of the partnership which arose prior to admission, so long as such liability

relates to an action taken, or omission occurring prior to admission, or the obligation

arises under a contract or a commitment made prior to admission.59

A partner

withdrawing from a partnership in violation of the partnership agreement is liable to the

partnership and the other partners for damages caused by the wrongful withdrawal.60

The

withdrawing partner may also be liable for actions committed by the partnership while he

was a partner.61

Under the TRPA, a creditor must exhaust partnership assets before collecting a

partnership debt from an individual partner, except in limited circumstances.62

Generally,

the creditor must obtain a judgment against the partnership, which is a change from prior

law. Also, a judgment against the partnership is not automatically considered to be a

judgment against its partners, who must be served individually in the action to be

bound.63

Even with these restrictions on collection of partnership assets, the unlimited

liability exposure of partners in a general partnership makes it a poor choice for liability

protection of its members.

3. Limited Partnerships

58

TRPA § 3.04; TBOC § 152.304(a). See E. & J. Gallo Winery v. Spider Webs, Ltd., 129 F.Supp.2d 1033

(S.D.Tex. 2001). 59

TRPA §3.07; TBOC § 152.304(b). 60

TRPA §6.02(c); TBOC § 152.503(c). 61

In re Keck, Mahin & Cate, 274 B.R. 740, 745-47 (Bky. N.D. Ill. 2002) (malpractice claim). 62

TRPA § 3.05; TBOC § 152.306. 63

TRPA § 3.05(c); TBOC § 152.306(a).

14

A general partner in a limited partnership has the same unlimited liability as does

a partner in a general partnership.64

A limited partner‘s liability for debts of or claims

against the partnership is limited to the limited partner‘s capital contribution to the

partnership, plus any additional amounts agreed to be contributed.65

However, the

limited partner‘s protection may be withdrawn if the partner participates in the

management of the partnership.66

Safe harbor provisions in the statute allow a limited partner to consult with and

advise the general partner, acting as a contractor for or an agent or employee of the

limited partnership or of a general partner, proposing, approving or disapproving certain

specified matters relating to partnership business, or the winding up of the partnership

business, or guaranteeing specific obligations of the partnership.67

A limited partner who knowingly permits its name to be used in the name of the

partnership will be liable to creditors who extend credit to the partnership without

knowledge that the limited partner is not a general partner.68

A corporation may serve as

the general partner of a limited partnership, but the piercing of the corporate veil doctrine

may be applied to reach shareholders of the corporate partner.69

The statute authorizes a limited partnership to register as an LLP by complying

with the provisions of the TRPA or TBOC, where the general partner‘s liability would be

limited to the debts or obligations of the limited partnership only as provided in TRPA §

3.08(a) or TBOC § 152.801.

64

TRPA § 4.03(a); TBOC § 153.152. 65

TRPA § 3.03; TBOC § 153.102. 66

In Texas, a partnership may be pierced to impose liability on its owners who are either general partners

or limited partners who participate in the control of the business. TRPA, § 3.03(a); TBOC § 152.303(a). 67

TRLPA § 3.03(b); TBOC §153.103. 68

TRLPA § 3.03(d); TBOC § 153.102. 69

Grierson v. Parker Energy Partners 1984-I, 737 S.W.2d 375, 377-78 (Tex.App.-Houston [14th

Dist.]

1987, no writ).

15

Assets of the limited partnership are protected from the limited partners‘ own

individual creditors. A judgment creditor‘s sole remedy against a limited partner who

does not actively manage partnership business is to seek a charging order against that

limited partner‘s interest. Under a charging order, distributions attributable to that

partner will instead be made to the judgment creditor who has obtained a charging order.

However, the judgment creditor usually has no right to compel distributions or to demand

that the limited partnership interest be liquidated, or to participate in the management or

operation of the partnership. More importantly, a judgment creditor pursuant to a

charging order becomes an assignee of the partner‘s interest, and therefore is subject to

income tax on its pro rata share of the partnership income—whether distributed or not.

The general partner of the partnership controls the timing of distributions, making

the attachment of a partner‘s interest through a charging order less attractive to a

judgment creditor who may wind up paying substantial income tax on an asset that has

not been actually received.

It remains to be seen whether Texas will adopt new section 703 of the Uniform

Limited Partnership Act (2001), which would allow a judgment creditor with a charging

order to foreclose on that partner‘s or member‘s interest. The current version of section

703 adopted in Texas appears to be internally inconsistent, in that it provides that a

judgment creditor‘s sole remedy is a charging order, yet states that a partner‘s interest

may be redeemed before foreclosure occurs.70

This may be explained by

Tex.Civ.Prac.&Rem.Code § 31.002, which allows a court to otherwise apply a judgment

debtor‘s property to the satisfaction of the judgment, which would include foreclosure as

a remedy.

70

Tex.Rev.Civ.Stat.Ann., art. 6132a-1, § 7.03; TBOC §§ 153.256, 153.25.

16

Managers of the limited partnership have a higher fiduciary duty to the limited

partnership and the limited partners because of the manager‘s control over partnership

affairs.71

Unless otherwise provided in the partnership agreement, limited partners do not

owe a fiduciary duty to the other partners of the partnership. By agreement, the liability

of the general partner to the partnership and the other partners may be limited in the same

manner as in a general partnership.72

4. Limited Liability Partnership

LLPs do not protect a partner from liability arising from the partner‘s own

negligence, wrongful acts or misconduct, or from that of any person acting under that

partner‘s direct supervision and control. However, a LLP partner will not be liable for

the debts and obligations of the partnership incurred while the partnership is a registered

LLP. A LLP partner may still be liable if liability is imposed by contract independently

of the partner‘s status as a partner (e.g., a guarantor), or if imposed by law, including torts

committed by the partner while acting on behalf of the partnership.73

Two recent

unpublished cases illustrate these principles. In Deyoe v. Gray, Jansing & Associates,

Inc.,74

a proposal for engineering services was presented the president and sole

shareholder of a corporation, who also was the registered agent for limited partnerships.

He signed the proposal as ―approved‖ without any representative designation. He was

held personally liable on the contract following a bench trial. On appeal, he argued that

he had signed the proposal as the agent for the limited partnerships, which the

71

See Palmer v. Fuqua, 641 F.2d 1146, 1155 (5th

Cir. 1981). 72

TRLPA § 4.03(b); TBOC § 153.152. 73

TRPA, § 3.08(a); TBOC § 152.801. 74

2005 Tex.App. LEXIS 1975 (Tex.App.-Austin, March 17, 2005) (unpub. opn.).

17

engineering firm was aware of. Following traditional agency principles, the court of

appeals affirmed the judgment against the individual, holding that to avoid personal

liability, the person must sign in a representative capacity, as well as identify the

principal to whom the representative is signing on behalf of.

In Acar Inv. Partners VI Ltd. v. Gaus,75

two partners in a registered limited

liability partnership had signed a lease on behalf of the LLP and also a limited two year

guaranty. The partnership breached the lease agreement, and the landlord sued the two

partners individually under the lease and on their guarantees. On appeal, the court of

appeals reversed a summary judgment in favor of the two partners, holding that although

the lease was done in the name of the LLP, the two partners were individually liable

because they had failed to renew the LLP‘s registration at the time the lease was

executed. The court of appeals rejected the partners‘ argument that the landlord was on

notice that the lease was with a LLP, because the language of the statute, Article 6132b-

3.08(a)(1), specifically stated that a partner in a LLP ―is not individually liable for debts

and obligations of the partnership incurred…while the partnership is a limited liability

partnership.‖ Since the lease was signed after the LLP‘s registration had lapsed, the

individual partners and guarantors were personally liable for the partnership‘s

obligations.76

75

2005 Tex.App. LEXIS 379 (Tex.App.-Eastland, Jan. 20, 2005) (unpub. opn.). 76

In contrast, the court of appeals in Suttles v. Thomas Bearden Co., 152S.W3d 607 (Tex.App.-Houston

[1st Dist.] 2004), reversed a summary judgment against a corporation‘s president who signed a promissory

note in a representative capacity on behalf of his corporation, which was not identified in the body of the

note, but was identified in the signature block of the note.

18

5. Limited Liability Company (LLC)

One advantage of an LLC is that a member, unless otherwise provided, may

participate in the management of the company without losing its protected limited

liability status, as that member would in a limited partnership.

An LLC is treated as a stand-alone entity for contract and tort purposes.

Generally, a member‘s personal assets may not be attached for an LLC debt, whether in

tort or in contract. However, the protection of personal assets would not apply if the

member guaranteed a debt, or committed an intentional tort. A judgment creditor, as in

limited partnerships, is generally limited to a charging order against the member‘s

interest.77

The duties of Managers (or Members in a Member-only LLC) are generally

assumed to be fiduciary in nature, similar to fiduciary duties of corporate directors. The

LLC statute allows company agreements to expand or restrict the duties (including

fiduciary duties) and liabilities of Members, Managers, officers and other persons

affiliated with the LLC.78

6. Corporations

A corporation protects shareholders since their liability is generally

limited to their invested capital. Officers and directors are ordinarily protected from

personal liability arising from the activities of the corporation. However, corporate

officers and/or directors can always be held personally liable for torts that they personally

committed.79

77

See discussion of charging orders in reference to a limited partnership, infra. 78

TLLCA § 2.20.B; TBOC § 101.401. 79

See, Kingston v. Helm, 82 S.W.3d 755, 758 (Tex.App.-Corpus Christi 2002, pet. denied). See also, Gore

v. Scotland Golf, Inc., 136 S.W.3d 26, 32 (Tex.App.-San Antonio 2003, pet. denied) (following Kingston).

19

In exceptional circumstances, a court will ―pierce the corporate veil‖ or ―disregard

the corporate entity‖ to find a shareholder personally liable for the activities of a

corporation.80

Failure to observe corporate formalities coupled with preference to

shareholders of an insolvent corporation can result in fraudulent transfer liability under

the Texas Fraudulent Transfer statute81

, and in some cases, individual liability under veil-

piercing theories.

Directors of a corporation owe fiduciary duties of care, loyalty and obedience to

the corporation.82

The ―business judgment rule‖ makes a presumption that directors have

satisfied their fiduciary duties in making a business decision, so long as there is no

conflict of interest and the action is not ultra vires or tainted by fraud.83

If the business

judgment presumption is overcome or not applicable, then the burden shifts to the

director to justify the fairness of the transaction to the corporation.84

Generally, absent contrary language in a shareholder agreement, minority

shareholders have little say in the day to day management of the business. Management

is by a board of directors, unless delegated in part under bylaws to officers who report to

the board. Closely held corporations may dispense with the board or restrict the board‘s

powers to act automatically. Controlling shareholders owe a fiduciary duty to deal fairly

with minority shareholders.85

80

See TBCA article 2.21 which defines circumstances under which the court may pierce the corporate veil

in contract cases. The amendments to Article 2.21(A); TBOC § 21.223, preserved the right to establish

individual shareholder liability by a showing of actual or common law fraud. See, Farr v. Sun World Sav.

Ass’n, 810 S.W.2d 294, 296 (Tex.App.-El Paso 1991, no writ). 81

Texas Uniform Fraudulent Transfer Act (TUFTA). 82

See Gearhart Ind. Inc. v. Smith Intern. Inc., 741 F.2d 707 (5th

Cir. 1984). 83

Gearhart, 741 F.2d at 719-21. 84

Id., 741 F.2d at 720. 85

See In re Pure Res., Inc., 808 A.2d 421, 433 (Del. Ch. 2002).

20

Directors must make proper disclosure of any self-dealing and present corporate

opportunities to the board, which must approve this activity. Absent a provision to the

contrary in the bylaws, it is a breach of fiduciary duty of loyalty for a director to engage

in undisclosed self-dealing or usurping a corporate opportunity for his personal benefit.

Texas law permits a corporation to renounce in its certificate of formation or by action of

its board of directors any interest in business opportunities presented to the corporation or

one or more of its officers, directors or shareholders.86

Shareholders are personally liable

for their failure to make agreed upon contributions.87

The directors and shareholders vote on the dissolution of the corporation. Failure

to provide for payment of creditors upon dissolution may result in personal liability.

Corporate stock under state law is transferable, but shareholder agreements may

place restrictions on transfer.

B. Indemnity Provisions

Like corporations, members of a partnership, limited partnership, and LLC may

agree that their good faith actions undertaken in the best interests of the entity will be

indemnified by the entity in the event of a third party claim.

The TBOC expressly provides that a partner is not individually liable for

partnership obligations by contribution or indemnity, unless otherwise provided.88

A

written or oral partnership agreement setting forth indemnification or contributions

inconsistent with the statute may result in the loss of the limited liability shield.

86

TBCA art. 2.02(20); TBOC § 2.101(21). 87

This holds true with respect to partnerships and LLCs. 88

TRPA § 3.08(a); TBOC § 152.801.

21

A limited partnership is prohibited from indemnifying a general partner who is

found liable to the limited partners or the partnership or for an improper personal benefit

if the liability arose out of willful or intentional misconduct.89

A LLC may indemnify any of its Managers, Members, officers or other persons

subject to the standards, if any, set forth in the certificate of formation or company

operating agreement.90

The restrictions on indemnification applying to regular

corporations do not apply to a LLC.91

C. Impact of Management on Liability

As noted above, management may have serious consequences on any protection

from third party liability, dependent upon the entity involved.

Management does not have an impact for general partnerships or an LLC. It does

impact the protection afforded to a limited partner, who will protected status by

participating in non-safe harbor management activities of the partnership. For LLPs,

management will render that person responsible for his own acts or omissions, or those

employees which he directly supervises and controls, but the partner will not generally be

held responsible for the acts or omissions of other partners, or employees which they

directly supervise and control.

D. Other Sources of Liability

1. Merger or Conversion

Under Texas corporation law, the acquirer of a general partnership may not be

accountable for pre-closing liabilities. A merger or acquisition requires the approval of

specific persons in advisory and ownership roles. Corporations must obtain approval by

89

TRPA §§ 11.03, 11.05; TBOC § 8.102(b). 90

TLLCA § 2.20.A; TBOC § 101.402. 91

TBOC § 8.002(a).

22

the directors and shareholders. LLCs and LPs have freedom to contract the provisions

governing mergers or acquisitions, and any required approvals. If the LLC is controlled

by Managers, they must approve the action. Both the general partner and the limited

partners generally approve a limited partnership‘s acquisition or merger, subject to

contractual variances. Unless otherwise provided, both LLCs and LPs have no appraisal

rights or other formal structure for minority dissent.

Conversion of an entity does not generally impair prior creditors, since liability

flows through to the new entity without requiring further action.

2. Impact of Bankruptcy, Insolvency or Near Insolvency

If an entity nears insolvency, additional fiduciary duties accrue to management

and advisors. Ignoring these duties may lead to the imposition of personal liability. If a

corporation is insolvent, a fiduciary arises for both officers and directors to creditors of

an entity, who stand ahead in the line to get paid before the owners of the entity itself.

Generally such duties are analyzed in bankruptcy court, in adversary actions for

fraudulent transfers in contemplation of bankruptcy. If the managers and advisors were

advised and assisted by professionals, i.e., accountants and attorneys, then personal

liability may be imposed on them as well. If the entity is a public entity, then those

professionals now have to worry about potential criminal and civil responsibility under

Sarbanes-Oxley.92

92

The Sarbanes-Oxley Act of 2002, 107 P.L. 204; 116 Stat. 745; 2002 Enacted H.R. 3763; 107 Enacted

H.R. 3763. The intricacies of counsel‘s responsibilities under this Act are beyond the scope of this paper,

but have already spawned a cottage industry of writers, prognosticators, and attorneys‘ fees for lawyers

specializing in advising on corporate governance.

23

3. Corporate Manager of a Partnership, LP, or LLC:

If a corporation manages a partnership, limited partnership, or LLC, do the

directors of the corporation owe a fiduciary duty not only to the corporation‘s

shareholders, but also to the partners, limited partners, or members of the LLC that they

manage?

LLC Managers owe at least fiduciary duties of loyalty and care to their LLC

members, although the scope of that duty may be modified by contract. If a corporation

manages an LLC, then the starting point is whether the Regulations adopted impose a

fiduciary duty for the corporate manager to the members of the LLC.

Even if the corporate manager of an LLC, LP, or partnership owes a fiduciary, or

modified, duty to the members under the terms of the governing contract, it remains

unclear whether that duty also flows to the directors of the corporation as well, although

there is case law developed in Delaware to suggest that the duty may exist in the limited

partnership context.93

A Delaware limited partner case, In re USACafes, L.P. Litigation94

, provides

some guidance on this issue. The limited partner investors in the USACafes limited

partnership sued the partnership, the corporate general partner, and the corporation‘s

individual shareholders and directors for breach of fiduciary duty in authorizing the sale

of the partnership‘s assets for a deficient price because they allegedly received substantial

side payments from the buyer. The director defendants moved to dismiss the suit for

failure to state a claim, arguing they owed no duty of loyalty and care to the limited

partners, and that such duty was owed by the corporate general partner. The court

93

This discussion is principally based on an article published in the ABA Journal, Vol. 12, #6 (July/Aug.

2003) authored by Victor Peterson & Alison N. Zim, entitled ―Corporate Directors, LLCs and Liability.‖ 94

600 A.2d 43 (Del. Ch. 1991).

24

rejected this argument, holding that ―[t]he assertion by the directors that the independent

existence of the corporate general partner is inconsistent with their owing fiduciary duties

directly to the limited partners is incorrect.95

‖ The conclusion of the court was based by

analogy to trust law that one who controls property of another may not, without implied

or express consent, intentionally use or dispose of that property in a way that benefits the

holder of the control to the detriment of the property or its beneficial owners.96

The reasoning of In re USA Cafes, can easily be extended from the limited

partnership context to other forms of partnership or an LLC, to prevent self-dealing that

is detrimental to the interest of the entity being managed, or its members. Another

limited partnership case, Gotham Partners, LP v. Hallwood Realty Partners, LP97

,

reached a similar conclusion, holding that where the breach of a corporate general

partner‘s fiduciary duties are caused by its directors and controlling shareholder, they are

liable to the partnership and its members. Kahn v. Icahn98

, concerned a derivative suit

brought by limited partners against the corporate general partner and its sole shareholder,

CEO, and certain affiliates, claiming a breach of fiduciary duty by usurping business

opportunities of the limited partnership. However, the limited partnership agreement

permitted the general partner to compete with the business of the limited partnership,

which the court concluded created a safe harbor insulating the general partner from

breaching its fiduciary duties by competing with the limited partnership. In contrast,

investors in Wallace v. Wood99

, filed a derivative suit against the corporate general

partner for breach of fiduciary duty by seeking to circumvent a contractual ceiling on

95

Id., at 48. 96

Id. 97

795 A.2d 1,34 (Del. Ch. 2001). 98

24 Del. J. Corp. L. 738, aff’d, 746 A.2d 276 (Del. 2000). 99

752 A.2d 1175 (Del. Ch. 1999).

25

indebtedness for acquisitions. Following In re USACafes, the court held that ―officers,

affiliates and parents of a general partner may owe fiduciary duties to limited partners if

those entities control the partnership‘s property.‖100

If a fiduciary duty is found to exist to the members of a partnership, LP, or LLC

being managed by a corporate partner, the fiduciary duties of the directors of the

corporation may also conflict with the fiduciary duties owed to that entity‘s members.

Fiduciary duties may be imputed ―upward.‖ As the court stated in In re Monetary

Groups,101

:

A general partner in a limited partnership stands in a fiduciary relationship

with the limited partners of that limited partnership. [cites omitted] Atkins

was a general partner of TSG. Thus, Atkins owed a fiduciary duty to

TSG‘s limited partners. Additionally, TSG was a general partner of

Groups. Therefore, because Atkins owed a fiduciary duty as a general

partner of TSG and TSG was a general partner of Groups, Atkins‘

fiduciary duty extended to Groups.

The courts may also impute fiduciary duties ―downward.‖ Delaware‘s Chancery Court

has concluded that ―fiduciary duties may be imputed to a separate entity formed and

controlled by fiduciaries for the purpose of engaging in a transaction with an entity to

whom those duties are owed.‖102

In Texas, the Northern District Court recently discussed the In re USACafes

holding. While In re ParkCentral Global Litigation103

did not reject the idea of fiduciary

duties flowing upward or downward, the court held that potential plaintiffs must allege

100

Id. At 1178. 101

2 F.3d 1098, 1103 (11th

Cir. 1993). 102

Barbieri v. Swing-N-Slide Corp., 1997 Del. Ch. LEXIS 9. 103

2010 WL 3119403 (N.D. Tex. 2010).

26

―specific facts that lead to a reasonable inference‖ that there is a fiduciary duty that has

been breached.104

The basic lesson is that fiduciary duties, unlike liability to third parties for entity

obligations, may not be avoided structurally by interposing entities, and claiming that the

controlling members of those entities are immune from responsibility because the

fiduciary duty does not flow up or down to them.

4. Liability for Attorney’s Fees

The choice of entity has a critical impact on whether a business may be held liable

for attorney‘s fees should a judgment be rendered against the business. In Baylor Health

Care System v. National Elevator Industry Health Benefit Plan, 105

the District Court for

the Northern District of Texas examined the plain language of Section 38.001 of the

Texas Civil Practice and Remedies Code. Section 38.001 provides, in pertinent part, that

―a person may recover reasonable attorney‘s fees from an individual or corporation, in

addition to the amount of a valid claim.‖ Notwithstanding this express language, the

Texas Supreme Court and many other appeals courts have allowed for the recovery of

attorney‘s fees from business entities other than individuals or corporations.106

However,

none of these cases ever raised the issue of recoverability of statutory attorney‘s fees

from a defendant under the ―individual or corporation‖ language because the issue was

not presented on appeal. The sole federal case that does discuss the recoverability of

statutory attorney‘s fees concluded that partnerships are not included among the defined

104

Id. at *7. 105

2008 WL 2245834 (N.D. Tex. 2008). 106

See, e.g., Bohatch v. Butler & Binion, 977 S.W.2d 543, 547 (Tex. 1998) (affirming award of statutory

attorney‘s fees against a law firm partnership under Tex Civ. Prac. & Rem.Code §38.001); see also Apache

Corp. v. Dynergy Midstream Servs., Ltd. P’ship, 214 S.W.3d 554 (Tex.App.-Houston [14th Dist.] 2006, no

pet.) (awarding attorney‘s fees against a limited liability company under Tex Civ. Prac. & Rem.Code

§38.001)

27

parties against whom a claim for attorney‘s fees may be made. 107

The Code Construction

Act defines ―person‖ to include ―partnerships.‖108

It follows that Section 38.001 was

drafted to intentionally exclude those who by definition are not ―individuals‖ or

―corporations.‖ Yet because this issue is rarely raised on appeal, many business entities

may be held liable for attorney‘s fees that they may not be required to pay.

III.

Final Advice

From a limited liability perspective, the entity of choice for most small businesses

would be a LLC, whether single-member or otherwise. If passive investors are going to

be involved, then consider a limited partnership. Both of these vehicles allow for flexible

operations of the business without the formalities required of a corporation, and provide a

shield of protection from third-party creditors. The downside to a limited partnership is

that it must have a general partner, and limited partners cannot participate in the

management without losing their protected status. To avoid these problems, having a

corporation or LLC be the general partner allows for some measure of personal

protection from individual liability.

It is important and essential to have a written partnership or operating agreement

that states the essential rules governing the operation of the business, especially in the

case of member withdrawals. In the absence of such written agreements, governance

defaults to the statutory provisions, which may not cover all issues which may arise in the

operation or termination of the business.

107

Ganz v. Lyons P’ship, L.P., 173 F.R.D. 173, 173-175 (N.D. Tex. 1997). 108

TEX. GOV. CODE. §311.005 (2005).